WEALTH HEALTH: Should you buy the biggest, hottest ETFs?

Friday

There are nearly 2,000 exchange-traded funds now in the United States, but more than half of the money that rushed into ETFs in August went into just 10 of them.

That means that the big 10 sucked up about $16 billion in inflows during August, while the rest of the industry – the other 1,900 issues combined -- drew roughly $15 billion.

It raises a legitimate question among ETF and fund investors as to whether they want to follow the herd into these giants, or take a different path.

To be sure, there is no one right answer, but if more than half of the money going into ETFs is rushing to 10 funds, it’s clear that a majority of investors should at least consider the question.

Long before the advent of ETFs, size mattered in the fund business. Issues like Fidelity Magellan (FMAGX) and Growth Fund of America (AGTHX) became household names and magazine cover subjects. Their size alone was an endorsement, seen by novice investors venturing into funds as a sign of safety.

Over time, the list of the largest funds started to show the progress of index funds, as the Vanguard Index 500 (VFINX), usurped all active managers by the late 1990s to become the largest single fund in the industry.

Where traditional giant active funds had the attraction of a successful manager, index funds promised to deliver the returns of a specific asset class; as investors moved from wanting to give a manager the power to move money around to instead controlling how their assets were allocated, indexing took off, particularly with the advent of exchange-traded funds. ETFs trade like stocks – minute-by-minute, rather than at the end of the trading day like a traditional fund – making them the ideal control choice for investors looking to take charge of their portfolio.

There’s no denying that size matters in all types of funds, but how it matters depends on the situation. An active manager with a strategy that can’t handle huge money flows wants to close the fund to stay small; by comparison, a new ETF that can’t attract critical mass – generally considered to be between $25 million and $50 million – may be in jeopardy of closing, as new issues often fold if they can’t amass sufficient assets to be profitable.

The 10 ETFs that took half of fund flows in August don’t have that worry; the question with them is whether they are too big.

In this group, size begets size; they get bigger because they are big, not because they somehow are better or better-constructed. They are high-volume, broad-based, low cost and easy-to-hedge, which keeps them front-and-center with traders.

All of that demand results in some of the tightest bid/ask spreads in the industry. That means better pricing, which is important to institutional money managers who trade so much that pennies per transaction add up to real money.

For the average individual investor planning to buy-and-hold an ETF, however, the minute differences in execution don’t amount to much on small positions held for a long time.

Thus, it’s more important to find ETFs that truly meet their needs, and that they understand enough so that they will stick with their allocation plans even when the market is working against them.

Thus, while the SPDR S&P 500 ETF represents the index, an investor might decide they’d rather own just the growth or value stocks in the index, or that they would prefer to spread their money to the stocks evenly (rather than based on market capitalization), or that they would prefer to focus on companies on the index that consistently raise dividends and more. Likewise, an investor might want to get away from the QQQ Trust because the index is nearly two-thirds invested in technology stocks.

In short, it’s better to own a fund because you want your money exposed to what it does, than because it’s big and famous.

Mark Salzinger of the No-Load Fund Investor noted that the Big 10 mostly have been good performers of late, “thereby [attracting] a lot of attention. In other words, they are momentum investments that could be expensive and ripe for reversion to the mean or a big correction, both because the recent operating performance of their holdings attracts new competition and because investors have bid up their valuations.”

It’s easy to go with what you know – and what everyone else seems to be buying -- but personalizing your asset allocation isn’t easy. It’s better to do some research and look for the mix of funds that serves your needs and give you the courage to hang on when the market turns than to buy what’s popular now.

Max Chen of ETFTrends.com noted that small traders gravitate toward the Big 10 “due to a herd mentality where they see that a lot of money is going into these ETFs, and they feel safer knowing that they can’t go wrong with the investments, or at least suffer with everyone else if the markets turn.”

ETF investors should do their own research to decide which funds fit their profile, rather than following the herd.

Where the industry is investing in ETFs is interesting; where your money belongs – based on your personal needs and objectives – is important.

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.